ECB preview: The charts that should keep Mario Draghi up at night

The risk of deflation may be rising in the euro zone, but economists don’t expect the European Central Bank to make more moves to fight it on Thursday.

While ECB President Mario Draghi is expected to use his monthly press conference to elaborate on measures taken two months ago — a further cut in its key lending rate to just 0.15% and a negative rate of 0.1% on deposits held at the central bank, among others — strategists say charts like these illustrate the challenge in ultimately convincing markets that the central bank is committed to chasing off the danger of deflation.

A market-based measure of inflation expectations is falling:

This chart, courtesy of St. Louis Federal Reserve Bank economist Alejandro Badel, shows that one-year breakeven inflation expectations calculated from Italian debt yields have dropped sharply since early May, when Draghi said the central bank would be “comfortable” taking steps to boost inflation. Breakeven inflation expectations are calculated by measuring the extra yield provided by a nominal debt security compared to the yield on inflation-indexed debt.

Draghi is likely to adopt a dovish tone, holding the door open for quantitative easing in the future, if needed. That’s assured, in part, by a further decline in the annual rate of inflation to 0.4% in July, the lowest reading since October 2009 and far below the ECB’s target of near but just below 2%.

Draghi has repeatedly said that deflation doesn’t appear to be a danger, but has acknowledged that an extended period of very low inflation can be dangerous. Providing some margin of comfort, the fall in inflation is seen down in part due to falling prices for food and oil.

Russia worries are hitting German economic sentiment:

Sentix

“We expect [Draghi's] Q&A session to be dominated by questions about the impact of recent EU and U.S. sanctions against Russia on the euro-zone economy and financial system,” said Elwin de Groot, senior euro zone strategist at Rabobank in Utrecht, Netherlands.

Fears that tougher sanctions against Russia for its role in the Ukraine conflict could hurt German exporters and threaten the flow of Russian natural gas have taken a toll on economic sentiment in Germany. Europe’s largest economy took the biggest hit in the latest Sentix sentiment readings.

It hasn’t been all doom and gloom for ECB policy makers. De Groot argues the ECB’s “forward guidance” policy and recent monetary-policy efforts have successfully held down interest-rate expectations. That’s finally taken some air out of the euro
/quotes/zigman/4867933/realtime/sampledEURUSD, which last month dropped below $1.34 for the first time since November.

A weaker euro is a welcome development for euro-zone exporters. It could also help put some upward pressure on inflation by lifting import prices.

Credit growth:

ECB, Eurostat, Danske Bank

Lending to the private sector continues to fall across the euro zone. But the pace of the decline has at least slowed, leaving some economists to argue the glass is half full. Writes Pernille Bomholdt, senior analyst at Danske Bank in Copenhagen:

The latest figure for loans to the private sector showed a slower pace of decline, while the ECB’s Bank Lending Survey for Q2 showed that banks eased credit standards. Weak bank lending has been a significant headwind to the ongoing recovery and, according to the ECB, a third of the output gap in the periphery can be explained by weak credit growth. Hence, the improvements are much needed.

Meanwhile, the ECB should also welcome a fall in interbank interest rates to an average of 0.04% in July from 0.26% in May, said Jennifer McKeown, senior European economist at Capital Economics. Also, the yield on 10-year German government bonds
/quotes/zigman/4869083/delayedDE:10YR_GER, or bunds,has dropped to a record low and peripheral yields have fallen too, she noted.

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